Stillborn Enterprises: Calculating Expectation Damages Using Forensic Economics ROGER I. ABRAMS* DONALD WELSCH** BRUCE JONAS*** I. INTRODUCTION Courts developed the common law within a dynamic economic, political, social, and scientific context. Their environment for decisionmaking grew out of perceived needs of commerce, the power and influence of competing interest groups, and the availability of valid methods of scientific measurement. The negligence action, for example, was a product of the economic developments of the early nineteenth century Industrial Revolution. Driven by a desire to protect the nascent manufacturing industry against liability for the inevitable injuries it caused as "the price of progress," 1 common law courts required injured parties to prove a defendant's lack of due care.2 In this century, the torts pendulum has swung in the opposite direction. Courts have imposed strict liability on manufacturers whose defective products injure consumers unable to protect themselves.3 The common law changed as methods of scientific proof improved. For example, traditionally a person could not recover for emotional damage absent a "touching," with the one exception of a common law assault.4 Courts doubted the genuineness of the plaintiffs claimed emotional injury, and that skepticism resulted in a flat rule barring recovery. Courts changed the rule 5 when psychological testimony gained acceptance. * Dean and Professor of Law, Rutgers School of Law-Newark. B.A., 1967, Cornell University; J.D., 1970, Harvard Law School. ** Forensic economist. B.A., 1961, Lafayette College. M.A., 1963, Rutgers University. Ph.D. (Econometrics) (ABD), 1968, New School for Social Research. ***Legal accountant. B.B.A., 1969, Hofstra University. I Beatty v. Central Iowa Ry. Co., 12 N.W. 332, 334 (Iowa 1882). 2 Prior to this development, defendants were held liable without proof of fault in an action in trespass for injuries caused directly to the plaintiff. See WILLIAM L. PROSSER, THE LAW OF TORTS § 7, at 29 (4th ed. 1971). Under a negligence standard, plaintiff would have to prove a failure of care on the part of the defendant, see id. § 30, at 143, potentially a substantial burden. 3 The California Supreme Court, in Greenman v. Yuba Power Products, Inc., 377 P.2d 897 (Cal. 1962), stated that the purpose of imposing strict liability was "to insure that the costs of injuries resulting from defective products are borne by the manufacturers that put such products on the market rather than by the injured persons who are powerless to protect themselves." Id. at 901. 4 See PROSSER, supra note 2 § 10, at 37-38. 5 "[W]hile physical manifestation of the psychological injury may be highly persuasive, such proof is not necessary given the current state of medical services and advances in psychology." Scott D. Marrs, Mind over Body: Trends Regarding the Physical Injwy OHIO STATE LAW JOURiVAL [Vol. 57:809 Common law contract principles also evolved over time. For example, at common law, contracts negotiated by minors were held unenforceable.6 Some courts later recognized that minors might have the capacity to participate in commerce and jettisoned the per se rule in favor of a multi-variable analysis, allowing the enforcement of promises by minors in certain instances. 7 Yet despite the evolution of the law, courts have had (and continue to have) particular difficulty addressing contract damage issues involving new businesses that fail, the so-called "stillborn enterprises." A new business might not reach viability with a sustainable operating performance after the initial start-up as a result of a breach of contract. For example, a supplier might not provide needed goods and services; a source of capital might not provide promised financing; a contract partner might fail to provide necessary patents, licenses, or trademarks. When any of these parties fail to fulfill contract promises, a cause of action might arise. The standard measure of damages for a breach of contract is the injured party's expectations. 8 When a plaintiff is an on-going enterprise with an established operating performance, courts can, with some confidence, predict sales loss and costs caused by a contract breach. Expectation damages can be based on lost profits, with prior profits a reasonable measure of projected loss. In the stillborn enterprise case, however, the defendant's breach prevents the plaintiffs business (or a portion of plaintiff's business) from becoming fully established. The new enterprise does not have a record for sales, costs, and operating performance upon which a court could rely in estimating damages. Without this record upon which to base calculations, the court's range of values is quite broad due to a multitude of variables. How do you calculate expectation damages suffered by a company that has no prior profits? Under the traditional rule, known as the "new business rule," courts ruled that, in the absence of prior data, estimates of expectation damages were speculative, Requirement in Negligent Infliction of Emotional Distress and "Fearof Disease" Cases, 28 TORT& INs. L.J. 1, 11 (1992) (quoting James v. Lieb, 375 N.W.2d 109, 116 (Neb. 1985)). Jurisdictions that abandoned the physical injury requirement have done so "in favor of a greater reliance on general tort law principles and the sophistication of jurors and the medical profession." Id. at 39. 6 See JOHN D. CALAMARI & JOSEPH M. PERILLO, THE LAW OF CoNTRACrs § 8-2, at 232 (2d ed. 1977); see also SAMUEL WILLISTON, A TREATISE ON THE LAW OF CoNTRAcrs § 9.1 (Richard A. Lord ed., 4th ed. 1993). 7 See Steven Wolfe, A Reevaluation of the Contractual Rights of Minors, 57 UMKC L. REv. 145 (1988) (discussing the three jurisdictions that allow minors to contract and the problems with the per se rule). 8 [An] injured party has a right to damages based on his expectation interest as measured by (a) the loss in the value to him of the other party's performance caused by its failure or deficiency, plus (b) any other loss, including incidental or consequential loss, caused by the breach, less (c) any cost or other loss that he has avoided by not having to perform. RESTATEMENT (SECOND) OFCONTRACrs § 347, at 112 (1981). 1996] STf.LLBORN ENTERPRISES remote, and uncertain, and they would award no such damages. 9 Commentators rightly criticized this judicial approach. Why should courts reward contract-breaking conduct by insulating a defendant from liability? It did not seem fair. 10 Public policy should encourage promise keeping. New enterprises serve a critically important public purpose: they furnish capital to a free market economy. Public policy, evidenced here by the common law, should encourage risk taking. Undermining the sanctity of contracts certainly would chill entrepreneurial spirit. Most states have now abandoned the traditional new business rule and adopted a uniform standard for recovery in all contract actions. The stillborn enterprise plaintiff must demonstrate lost profits with "reasonable certainty" in order to recover.11 Courts reasoned that an absolute denial of contract recovery to stillborn enterprises was unfair and unnecessary. The stillborn enterprise situation presents an interesting example of how 9 The courts faced a similar situation in calculating damages issues for a one-time event with no prior history. See Chicago Coliseum Club v. Dempsey, 265 Ill. App. 542 (1932). There, the court stated: [ihe character of [a boxing match] was such that it would be impossible to produce evidence of a probative character sufficient to establish any amount which could be reasonably ascertainable by reason of the character of the [boxing match].... Such an entertainment lacks utterly the element of stability which exists in regular organized business.... ...Mhe performance in question is not susceptible of proof sufficient to satisfy the requirements and... the damages, if any, are purely speculative. Id. at 549-50. 10 "The new business rule ... is a rule that artificially reduces the injured party's expectation interest.... By denying anticipated future profits, the new business rule automatically precludes one important aspect of the expectation interest and, thus, artificially increases the gain to the breaching party from breaking his promise." Bernadette J. Bollas, Note, The New Business Rule and the Denial of Lost Profits "[MIen Keeping Their PromisesWhen Neither Side Can Get Anything by the Breaking of Them", 48 OHio ST. L.J. 855 (1987); see also Michael D. Weisman & Ben T. Clements, Protecting Reasonable Expectafions: Proofof Lost ProfitsforNew Business, 76 MASS. L. REV. 186, 188 (1991). The new business rule has been subject to widespread criticism on several grounds. One of its most serious problems is that it 'has served to frustrate the overall policy of seeking to put the nonbreaching party in as good a position as he would have been had the contract been fully performed.'... IThere is an inherent unfairness in denying a new business recovery because of the difficulty of proving lost profits where the difficulty is due to the defendant's wrongful conduct. Weisman & Clements, supra, at 188 (quoting Frank L. Williamson, Comment, Remedies- Lost Profits as Contract Damagesfor an Unestablished Business: 7he New Business Rule Becomes Outdated,56 N.C. L. REv. 693, 695 (1978)). 11 See infra Part II. OHIO STATE LAW JOURNAL [Vol. 57:809 the common law developed in response to heightened judicial sensitivity to fairness concerns. It also presents an opportunity to discuss the use of the expert testimony of a forensic economist and a legal accountant in proving expectation damages. In this Article, we first examine the historical basis for the no-recovery rule and the reasons asserted by the courts when they jettisoned the traditional approach. 12 We briefly sample cases to show the methods of proof courts have found suitable to prove damages with "reasonable certainty." 13 Although there was a good policy reason for the courts to abandon a per se rule of no liability, courts have not always found adequate evidence upon which to predict loss of profits.